How crypto-exchanges could be the saviour of a scandal-hit industry

Maxim Bederov, a serial entrepreneur and early-stage investor in a number of projects, including one of the first retail funds incorporating digital assets, writes that cryptocurrency exchanges are the linchpin of this nascent industry.

However, he warns that in the wake of the Bitfinex/Tether scandal and other incidents, and they need to clean up their act.

Exchanges play a key role in the USD300 billion coin-trading market’s growth by enabling investors to trade. However, despite the large volumes of money being handled by crypto-exchanges, there is little regulation. Although this is slowly beginning to change and rightly so.

The time of unregulated markets is over and if any crypto-exchange plans to be successful, obtaining a licence will be key. Over the next few years, transparency, accountability and security will be the three pillars of success for any exchange.

These attributes will be vital for the industry to move forward and gain credibility, particularly in light of the Bitfinex/Tether scandal.

Back in April the Office of the New York Attorney General (OAG) accused Bitfinex of using the reserves of affiliated cryptocurrency Tether to cover up a loss of USD850 million to payment processor Crypto Capital. It asserts that, by doing so, Bitfinex violated New York law and defrauded state residents.

Crypto Capital later said they could not send any funds as they had been seized by regulators in the UK, the US, Poland and Portugal. This, in turn, led to Bitfinex arguing that as the funds were seized, and not lost, they were theoretically recoverable.

Bitfinex and Tether – both owned by iFinix – went on to file a motion for the case to be dismissed, arguing that the OAG had no jurisdiction as the businesses were not operating in New York. But in July, the OAG countered the motion by submitting evidence showing that both firms had been operating in New York longer than claimed.

The legal battle remains ongoing, and it is clearly too early to speculate on any possible outcome, but it would appear likely that a defeat for iFinix could impact the wider crypto industry. In the worse case scenario, some believe that removing Tether’s USDT stablecoin from cryptocurrency markets could lead to a severe liquidity crunch, although other industry analysts think the market would continue to thrive.

Another case in point is wash trading by unscrupulous exchanges. This practice of creating fake trading volumes in order to boost public perception of how easy it is to buy and sell cryptocurrencies on their platforms is far more likely to happen when there is little regulatory oversight.

Companies like Russia-based Gotbit use bots to manipulate trading volumes to make a specific coin more recognisable on CoinMarketCap, the world leader in crypto data provision. Gotbit charges USD15,000 to create the illusion of active markets by listing a token on smaller exchanges in order to create enough volume to become listed on the market data site.
However, it’s worth noting that Gotbit founder Alexey Andryunion recently told Coindesk that he believes these smaller exchanges wouldn’t survive without the added volume. But as higher volumes also benefit the exchanges themselves, clamping down on manipulation is not necessarily worthwhile. 

The other problem facing the credibility of the industry is ongoing hack attacks on crypto exchanges. As recently as July 12, licenced Japanese crypto-exchange BITpoint lost JPY3.02 billion (about USD28 million) in a security breach.

The 50,000 users affected will be reimbursed with cryptocurrency, the exchange later said, although this raises questions whether customers could lose out due to price fluctuations. BITpoint director Kimio Mikazuki refused to comment on the latter point, it was reported.

The attack came just months after leading crypto-exchange Binance had more than USD40 million in bitcoin stolen in what it called a “large-scale security breach”. Recent analysis by Coinfirm showed that the attacker, or attackers, have since begun liquidating the stolen bitcoin on various other crypto-exchanges.

Indeed, the Cambridge Centre for Alternative Finance’s 2nd Global Cryptoasset Benchmarking Study said IT security was the major risk factor for all crypto-asset actors. It reported that a total of USD1.5 billion had been lost due to 58 identified breaches since 2011, with large exchanges particularly targeted. It added that there was a general reluctance to talk about security-related issues across the industry and that audit information sharing was not common practice.

So, in light of such scandals and losses, is greater regulation required to clean up the market and boost customer confidence? There are certainly moves in that direction.

Outgoing International Monetary Fund, and incoming European Central Bank, chief Christine Lagarde has acknowledged that digital assets are “shaking the system” in comments interpreted by many as hopeful that Europe could soon enact crypto-friendly legislation. Meanwhile both the European Banking Authority and the European Securities and Markets Authority have called for crypto rules at EU level.

And G20 leaders in June declared their support for Financial Action Task Force cryptocurrency guidelines that would make exchanges hand over user data to regulators. The initiative marks the first major attempt to set up a global approach to regulating the cryptocurrency sector.

The UK’s Financial Conduct Authority has also recently proposed a ban on financial instruments linked to cryptocurrencies, such as derivatives and exchange traded notes, warning that consumers were unlikely to understand their risks or value due to their “extreme volatility”.

To repair the cryptocurrency industry’s reputational damage and encourage wider participation in the market, rebuilding customer trust and improving transparency is a must.
The obvious way of doing this is through regulation. All successful crypto-exchanges should be seen to comply with, and maintain, standards and the best way of doing this is by obtaining a licence to trade.

Japan was the first country to regulate crypto-exchanges and several other countries have since followed suit. China did the opposite and banned them outright. But are all licenced crypto-exchanges as equal as each other? Perhaps not.

Estonia is known for its crypto-friendly licensing regime and reportedly issued more than 1,000 licences for crypto-operators in 2018. This triggered concerns about the number granted to offshore applicants, although the Estonian government has moved to tighten up legislation in recent months.

A case in point is the UK's FCA recent blacklisting of Solo Capitals, which is supposedly owned and operated by a company with an Estonian address. It warned that Solo Capitals was carrying out regulated activities in the UK which required authorisation that the company doesn’t have.

Crypto will only become mainstream when it has the public’s trust. But for that to happen, all the players will need to be seen to stick by the rules. To prevent repeats of scandals like Bitfinex/Tether, avoid unscrupulous practices such as wash trading and improve the industry’s image, regulation will be key.

For the future of the cryptocurrency sector belongs to exchanges that are legal, transparent and safe for customers. Only then will crypto become a safe and reliable asset for investors, traders from the traditional financial industry, and regulators.